3 "small ball" picks for a market without a strong trend

Remember this one? The trend is your friend. Or how about this saying? A rising tide lifts all boats?

And when the trend turns against us? When the market plunges, run for an exit until you see blood in the streets (or hear the sound of cannon) and then it’s time to get back in on the cheap.

Yes, markets with strong trends are relatively easy to navigate.

But how about a market without a strong discernable trend to drive stock prices? One that seems at the mercy of news? And that has rallied far enough so that while it’s not especially expensive, it’s not especially cheap either?

What do you do as an investor then? I think that’s the kind of market we’re in right now; one without a strong trend in either direction, but that seems inclined—maybe--to drift higher in the absence of bad news.

You can go for broke, swing for the fences, double down… You can make a big directional bet on the market and hope that you’ve called it correctly. If you’re right in your call, you’ll make out like a bandit. Get the direction wrong with a big directional bet and you’ll feel like you’ve been robbed by a bandit.

Or you can play “small ball” and take what the market gives you as its search for direction creates temporary bargains in individual stocks that you’d like to own for a while. “Small ball” is time consuming. It takes a whole lot more effort to invest this way than to go decide to load up on gold or to short Chinese banks. But in a market that’s searching for direction “small ball” is the best way to make some money while limiting your exposure to getting the big picture wrong.

It has the added value that if, as I believe now, the trend of global stock markets will be a whole lot clearer in six months than they are now, you will have preserved your capital diligently enough so that you can take advantage of an easier market.

Okay, a brief review of where we are both in terms of the technicals of the market and its macroeconomic underpinnings. And then on to my three “small ball” picks.

Beginning on December 19 with the Standard & Poor’s 500 at 1205, U.S. stocks staged a major rally, reaching 1368 intraday on February 21. That’s a gain of 13.4% in about two months.

And then the U.S. market went into a stall, moving essentially sideways over the next week or ten days. And Wall Street analysts started talking about the need for this rally to take a rest. Stocks were over-bought and they needed to either pull back or at least move sideways to build up a new foundation for a further advance.

And for a while last week if looked like investors might get exactly the clear downward trend some of these analysts had been forecasting. After closing at 1374 on March 1 (with an intraday high at 1376), the S&P 500 fell on Monday and Tuesday, March 5 and 6, to a close of 1343 (with an intraday low of 1340). It looked like stocks might indeed resolve the sideways move from an intraday high of 1368 on the S&P 500 by moving into a correction.

But that wasn’t to be. The S&P 500 recovered pretty much all it had lost at the beginning of the week by the end of the week, closing at 1371 on Friday March 9 with an intraday high of 1374.

Now I’m sure most investors—all those who are long stocks anyway—aren’t about to lament the failure of a correction to arrive as promised by the drop in stocks at the beginning of last week. If you’re long stocks, you aren’t wishing for a clear trend quite that much.

But it does leave us with the same market with the same lack of a strong trend that we’ve had since the rally that began 2012 stalled and began to move sideways in late February.

Of course, the rally stalled and started to move sideways because of more than just nervousness about the market’s technicals. The news from Europe, China, and the United States had something to do with it.

For example, as March began it started to look like the Greek rescue deal might come apart because not enough Greek bondholders would sign up to swap their old Greek bonds for new bonds with a lower face value and a lower coupon yield. At the same time investors got new data indicating that economic growth in the EuroZone would be even lower—even in Germany—than forecast earlier. In the U.S. the Federal Reserve said the economic recovery was weak enough so that the central bank would leave intact its policy of keeping interest rates near 0% through 2014 but strong enough so that the Fed wasn’t looking at a new program of quantitative easing in the near future. China cut its target for economic growth in 2012 to 7.5% from 8%, raising fears that China’s economy might be headed for a hard landing.

By the end of last week, however, those fears had receded if not vanished. 95% of Greek bondholders had decided or been “convinced” to swap their bonds. The U.S. jobs number showed a net increase of 227,000 jobs and growth in aggregate income. The lower Chinese target for growth turned from a forecast of a hard landing to one more reason for thinking that the People’s Bank of China would lower the bank reserve ratio again—perhaps as early as this month—and then move to an actual interest rate cut in June or so.

Which left us with a U.S. stock market that was still overbought and that hadn’t fallen enough for across the board bargain hunting. And where growth trends looked positive but worries about growth hadn’t been put to bed.

Currently one of the things that worries me most is earnings growth. Right now it looks like fourth quarter earnings growth for the S&P 500 stocks will finally come in near 6.1%--that would end a string of eight consecutive quarters of double-digit earnings growth. And the Wall Street consensus is moving toward a view that investors won’t see a return to double-digit earnings growth until the fourth quarter of 2012. That’s quite a retreat when as recently as August 2011 Wall Street was calling for double-digit earnings growth in the fourth quarter of 2011 and for every quarter in 2012.

At the beginning of March projected earnings growth for the S&P 500 had retreated to show a decline of 0.6%. That’s down from 0% growth projected for the quarter at the beginning of February, 3% growth projected on December 30, and 8% growth projected on September 30, 2011.

The drop in growth in 2012 isn’t as illogical as it might seem. Companies cut costs and then cut them again in 2010 and 2011—now that process is coming up against its limits and profit margins aren’t going to get the boost in 2012 that they did in 2011. European economies are still slowing as they slip into recession and that’s cutting revenues for U.S. exporters.

Valuing stocks when earnings growth comes into question gets rather challenging On March 9, the S&P 500 stocks traded at 15.86 times trailing 12-month earnings per share. That’s actually down from the 17.92 times trailing 12-month earnings per share that these 500 stocks commanded on March 9 2011. Stocks have rallied recently (although they’re not especially far ahead of where they were at the high of 1364 on April 29, 2011) but earnings have grown even faster, making them less expensive than they were in spite of the rally.

In fact, by some measures stocks are even cheap. On projected 2012 earnings the S&P 500 trades at a multiple of just 13.1. That’s well below the historical average of 14.6 on projected earnings per share for this index.

Of course, if earnings growth is headed for a slowdown in the first half of 2012, then the current forward multiple on the S&P stocks doesn’t say they’re cheap, but that Wall Street analysts and investors haven’t yet fully caught up with a worsening earnings picture. (Not to go too far down another road, but methods of valuation that depend on interest rates or cost of capital to calculate a target price also face difficulties ahead if interest rates stop falling and begin to climb. Long interest rates can do that even if the world’s central banks remain committed to super-low short-term rates.)

So what am I looking for as possible picks as I try to play small ball in this market?

Companies that have recently disappointed investors and been taken out to the woodshed by the market. I’m especially interested in stocks like that if, in the aftermath of the disappointment, growth forecasts for the company have been slashed to the bone. For example, in my March 6 post http://jubakpicks.com/2012/03/06/next-stop-in-the-traveling-global-financial-casino-china/ I suggested waiting until Home Inns and Hotels Management (HMIN) reported fourth quarter earnings on March 8 because the company might well disappoint. Sure enough, it did and the stock finished Friday, March 9, 12.6% below its March 5 price.

What was the company’s big sin? Not revenue. Revenue for the quarter came in at $208 million, above the consensus estimate of $191 million, and up 64% from the fourth quarter of 2010. At 12 cents a share, though, earnings badly missed Wall Street estimates of 28 cents. The problem was a $2.8 million loss from Motel 168, a chain recently purchased by Home Inns and Hotels and that hasn't yet been fully integrated into the company. A loss of $2.8 million might not seem like much, but total income for the quarter was just $5.2 million.

What other stocks might make good “small ball” plays?

How about a biotech such as OncoGenex (OGXI)? Short of a market meltdown that sends every investor screaming out of anything with a bit of risk, biotechnology stocks tend to march to their own drummer, going up on the progress of drug trials and corporate partnerships independent of what the market does. The stock sold off a bit (6%) from the March 1 high at $16.20 to the close on March 12.

OncoGenex has two drugs for treating prostate cancer in Phrase II and Phase III trials. Prostate cancer is a big disease with 200,000 to 220,000 new cases a year. Unlike many cancers, it is very treatable with a 100% five-year survival rate if the cancer is diagnosed early. Still 30,000 men die of the cancer in the U.S. every year because they weren’t diagnosed early enough. The race among drug companies is to find an effective treatment for those men who aren’t diagnosed early. OncoGenex has just signed a partnership with Teva Pharmaceutical Industries (TEVA) that includes a $60 million upfront payment and $370 million in potential milestones for the company’s Phase III drug OGX-011.

Or how about taking a really long view on the natural gas glut and making a “small ball” play on Ultra Petroleum (UPL). The company has one of the lowest cost structures in the U.S. natural gas industry. Of course, that doesn’t mean that even Ultra Petroleum is making any money with natural gas at $2.28 per million BTUs, but unless natural gas prices fall another 25% or so, Ultra Petroleum doesn’t look like it will need to raise significant new capital. That’s important because in the natural gas industry these days raising capital usually means selling off assets. Oil has about 6 times the energy content of an equivalent amount of natural gas. So all things being equal—which they never are—oil should sell at 6 times the price of natural gas. Right now, though, it sells at 47 times the price of natural gas. Granted that natural gas can’t substitute for oil in many uses, the price of natural gas is still just too low. Any company that can survive to get to the other side of this price collapse with some natural gas assets intact will be a long-term winner. (Ultra Petroleum is a member of my long-term Jubak Picks 50 portfolio http://jubakpicks.com// )

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Home Inns and Hotels Management as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/